Backtesting in trading helps you to generate results without risking your capital. By backtesting trading strategies, you’ll determine how well they would have worked in the past. Traders develop several strategies but not all of them will work.
Backtesting lets investment firms and individuals identify trading techniques that are truly profitable. Whenever backtesting shows that a model works, traders can use it confidently.
What is backtesting in trading?
Backtesting is a method of learning how viable a strategy is for traders. Experienced traders will never use a strategy with real capital unless they’ve backtested it first.
Traders might be reasonably sure that a model should work. However, there could always be a factor that they hadn’t considered. This could affect the results that they get with that particular technique.
Backtesting in trading uses historical data to evaluate models. Traders will understand how well the technique would have worked with real capital in the past. They might find that they would have lost money. If so, they have to make changes to that strategy.
Backtesting Strategies
Traders use several approaches for backtesting in trading. However, there are three common methods that deliver good results.
These are:
- Use a trading platform such as MetaTrader
- Check your strategy a specific backtesting software
- Use custom software
Later in this article, you’ll learn how MetaTrader helps with backtesting. You’ll also learn about other platforms that can be used for backtesting in trading.
MetaTrader provides you with programming capabilities. It offers another advantage as well. It’s the same platform that you will eventually use for live trading.
Use Specific Backtesting Software
Some traders like to use specific backtesting software. This type of application is ready to be used for backtesting. Traders only need to install it.
After installation, traders can use stock data with their backtesting software. They can select the backtest function in the software after adding the data. Following each test, they can adjust the inputs.
The software makes it easy to adjust the inputs to improve profitability. For example, some traders like to use a crossover strategy with moving averages. Backtesting software allows you to slow down one of the moving averages or even adjust both at the same time.
Use Custom Software
A developer can build custom software to match your needs. Python is popularly used for this purpose. Other programming languages such as R can also be used.
Custom-built backtesting software is usually expensive. However, it offers several advantages. Traders find that this option is more flexible. They’re not restricted in terms of how they can analyze their data.
Mix All Three Approaches
Some traders use all three approaches. For example, they may use specific backtesting software for common profiling. However, if they have a complex strategy that they want to test, they’ll build software from scratch. Although it’s more expensive, they’re able to implement their ideas without restrictions.
What can you backtest?
You can backtest any quantifiable idea. Forex traders can test their Forex trading strategies. Similarly, crypto traders benefit from backtesting in trading. People who trade options and futures can also backtest their ideas. In all of these cases, traders should bear in mind that past performance is not a guarantee. It’s not indicative of the outcomes that they’ll get in the future.
Experienced programmers can help you to develop your ideas. They code your idea in the same language that’s used by your trading platform. You don’t need to know how to code.
Programmers can help algorithmic traders who are aiming for strategy diversification. This is comparable to portfolio diversification. However, this type of trader focuses on using different strategies. They’re not as focused on using different assets.
Avoid Backtesting Bias
Traders should always try to avoid backtesting bias. Stock traders should test a broad range of stocks. Forex traders should test diverse currency pairs with their models. For example, a model for cryptocurrencies should not only be backtested with Bitcoins.
Different data sets should always be used throughout the process. We’ll go into further detail later in this article.
Picking and choosing data sets isn’t good. This results in a model that is flawed. Similarly, your model should also be backtested against different time periods.
Prevent Look Ahead Bias
Traders are sometimes prone to look ahead bias. With this type of bias, they unconsciously incorporate the information in the test. This is based on what they know will happen.
It’s almost like they’re a time traveler from the future. They adjust their behavior in the past. They include data that they wouldn’t usually have access to.
Models that are developed with look ahead bias incorporate facts that would not normally be available. Look ahead bias results in a flawed model. Institutional investors and individuals must be careful about the type of data that they include in their backtests
You Can Adjust Your Inputs with Backtesting
Traders sometimes use strategies that are based on moving averages. Backtesting helps them to figure out which moving averages work best. For example, shorter moving averages are more reactive. Longer moving averages are more lethargic. That’s because they reflect prices over a longer period.
Some traders even wonder if 200-day moving averages have lost their ability to time the market. Traders can backtest this and other lengths of moving averages. Doing so helps them to understand which ones perform best on the historical data.
Backtesting in Trading Reduces Losses
Traders use backtesting for several reasons. For example, it increases their profits. Traders who don’t test their strategies are more likely to lose money.
A strategy won’t perform exactly as you want it to all the time. That’s particularly true in the first stages of its development. Testing it with historical data helps you to determine its win/loss ratio.
You’ll learn whether it’s profitable 35% of the time or even 70% of the time. That information helps you to decide whether you should use it as it is or make further adjustments. You might also decide to use a different strategy.
Traders Become More Experienced
New traders are always looking for ways to shorten their learning curve. Backtesting in trading helps with that. You will gain experience quickly through this process.
Techniques such as forward testing and out-of-sample testing also help. They show new and experienced traders a system’s true colors. Traders who only rely on one method are sometimes misled. All three help traders to determine a system’s viability.
Traders Recognize Patterns Quickly After Backtesting
The human brain is designed to recognize patterns. During backtesting, traders look at diverse price actions. They also view different patterns. Over time, this trains their eyes to recognize patterns quickly.
Technical traders use charts. Candlestick charts are popular. These give lots of information. Unfortunately, they’re hard to read at first.
Backtesting helps you to learn candlestick patterns. This happens naturally. Traders learn other chart patterns as well.
Traders who recognize patterns quickly can make good decisions rapidly. This gives them an advantage when they’re trading in markets that change quickly. For example, Forex traders can respond to more opportunities if they recognize them immediately.
How many trades should you backtest?
Some traders think that you should test at least 100 trades. You definitely should not rely on a few trades. The results obtained from five or 10 trades don’t give you a good picture of how your strategy will perform.
Weaknesses of Backtesting in Trading
Traders sometimes over-optimize their system during backtesting. This means that they end up with a model that performs very well with historical data. However, it doesn’t do as well with live trading. This is especially true with the Forex market, which can change at any time.
Traders must be careful about maximizing their profits on historical data. A system that looks impressive on paper can be unreliable in real trading. That’s because it was tailormade for a particular time frame. It works best with that set of historical data.
Forex traders and other traders have found a way to address this problem. They also test their optimized model on other sets of historical data. This out-of-sample data behaves like new data.
Traders who backtest their strategies know that there are shortcomings that they must plan for. For example, you might backtest that strategy with a specific market volume. However, it may not perform the same way with a different market volume.
Similarly, other market conditions may change. Even one change can make a difference. This is why backtesting can be so intensive.
Traders must assess the impact of several inputs. They will learn how effective their strategy really is. It can be hard to do this manually. That’s why so many traders use backtesting software to help with the process.
You Can Use MetaTrader for Backtesting In Trading
Many platforms facilitate backtesting in trading. In fact, it’s easy to test your ideas in just a few clicks. MetaTrader 4 can help you to check complex systems. Likewise, MetaTrader 5 can receive a wide range of inputs.
MT4 lets you select any market that you want to backtest. You can scroll to go back in time as far as you wish. You can plot your preferred indicators and trading tools on your chart.
MetaTrader lets you mark your entry and Stop-Loss during backtesting. You can also mark your profit target, just as you would if you were trading live markets.
You can record the results of each trade. Coding is not required. Backtesting is free in MetaTrader. Using an algorithmic method results in fewer errors than manual backtesting.
Experienced traders can design a wide range of strategy portfolios with backtesting software. They have tests for different markets and asset classes. They also have a portfolio of tests for different times. Several personalized investment strategies for stocks and other instruments can be developed in this way.
Benefits of EA Studio for Backtesting In Trading
EA Studio helps with backtesting. Traders who use EA Studio for backtesting benefit in several ways. EA Studio has a lot of tools for you to use. You can also monitor lots of statistics with each strategy that you prefer.
EA Studio lets you change your strategy in several ways. You can change a single input. EA Studio shows you the impact.
Forex traders can test strategies thoroughly. They can do this for all of the currency pairs that they like to trade.
EA Studio and MetaTrader Are Both Good Options
Generally, it doesn’t matter whether you use EA Studio or MetaTrader for backtesting in trading. Both of them tend to give you similar results. For example, your strategy won’t be profitable 80% of the time in MetaTrader but only brings profits 70% of the time when you backtest in EA Studio.
However, EA Studio offers you a lot of statistics. On the other hand, MetaTrader gives you a comprehensive report. If you use both programs to backtest the same strategies you’ll benefit. You will easily identify the strategies that have more profits than losses.
Overall, EA Studio is better for backtesting than MetaTrader. This is because backtests on EA Studio are done much more quickly than backtests on MetaTrader. In addition, EA Studio takes a more pessimistic outlook, so it gives you a more accurate picture of what will happen under all market conditions.
MetaTrader 4 and MetaTrader 5 help with backtesting in trading. Some traders test their plans on both EA Studio and MetaTrader.
Traders can use both EA Studio and MetaTrader for backtesting crypto strategies and Forex techniques. MetaTrader has several features which make it an asset. You’ll get additional insight on your strategies when you use it with EA Studio.
Benefits of Backtesting in Trading with MetaTrader
Metatrader doesn’t allow you to change the strategies that you use in many ways. EA Studio lets you make several changes and test them. In this way, you’ll increase your chances of getting a profit from your trades.
Despite that, many traders like to backtest their ideas in MetaTrader. This is because they can do backtesting right up to the present moment. This is very helpful if a trader likes to test new strategies frequently.
In MetaTrader, you can easily adjust details that affect your profit on each trade. For example, while backtesting you can set a spread of about eight points. Although this is costly, it gives you a better idea of how well your plan will work under diverse conditions.
Several Forex brokers have a floating spread. Traders know that this badly impacts their trades. That’s because at times the spread will be higher. Unfortunately, backtesting in trading with a low spread is not a good idea. It will not account for these brokers.
Sometimes a trader may sign up for an account with a new broker. However, they might not be certain of how that broker will perform. MetaTrader makes it easy to learn what you can expect from the broker.
Backtesting your strategies lets you know if the broker is suitable. Some brokers aren’t a good match for the models that you plan to use.
Cryptocurrency traders can benefit from backtesting their strategies in MetaTrader. It works well for Bitcoin and many other popular cryptocurrencies.
The crypto market is volatile. That’s why it’s important to do your due diligence. Aim to test all of your strategies. Do that before you use them with real cash.